Single-Index Model

To simplify analysis, the single-index model assumes that there is only 1

macroeconomic factor that causes the systematic risk affecting all stock
returns and this factor can be represented by the rate of return on a market
index, such as the S&P 500. According to this model, the return of any stock
can be decomposed into the expected excess return of the individual stock
due to firm-specific factors, commonly denoted by its alpha coefficient (α),
which is the return that exceeds the risk-free rate, the return due to
macroeconomic events that affect the market, and the unexpected
microeconomic events that affect only the firm. Specifically, the return of
stock i is:

ri = αi + βirm + ei

The term βirm represents the stock's return due to the movement of the
market modified by the stock's beta (βi), while ei represents
the unsystematic risk of the security due to firm-specific factors.

Macroeconomic events, such as interest rates or the cost of labor, causes

the systematic risk that affects the returns of all stocks, and the firm-specific
events are the unexpected microeconomic events that affect the returns of
specific firms, such as the death of key people or the lowering of the firm's
credit rating, that would affect the firm, but would have a negligible effect on
the economy. The unsystematic risk due to firm-specific factors of a portfolio
can be reduced to zero by diversification.

The index model is based on the following:

 Most stocks have a positive covariance because they all respond

similarly to macroeconomic factors.
 However, some firms are more sensitive to these factors than others,
and this firm-specific variance is typically denoted by its beta (β), which
measures its variance compared to the market for one or more economic
factors.
 Co variances among securities result from differing responses to
macroeconomic factors. Hence, the covariance (σ2 ) of each stock can be
found by multiplying their betas by the market variance:
 Cov(Ri, Rk) = βiβkσ2

This last equation greatly reduces the computations, since it eliminates the
need to calculate the covariance of the securities within a portfolio using
historical returns and the covariance of each possible pair of securities in the
portfolio. With this equation, only the betas of the individual securities and the
market variance need to be estimated to calculate covariance. Hence, the
index model greatly reduces the number of calculations that would otherwise
have to be made for a large portfolio of thousands of securities.

Security Characteristic Line

The comparison of a stock's excess return can be plotted against the market's
excess return on a scatter diagram using linear regression to construct a line
that best represents the data points. This regression line, called the security
characteristic line (SCL), is a graph of both the systematic and the
unsystematic risk of a security. The intercept of the regression line is the
alpha of the security while the slope of the line is equal to its beta.

Single-Index Model and the Capital Asset Pricing Model

The alpha of a portfolio is the average of the alphas of the individual

securities. For a large portfolio the average will be zero, since some stocks will
have positive alpha whereas others will have negative alpha. Hence, the alpha
for a market index will be zero.

Likewise, the average of firm-specific risk (aka residual risk) diminishes

toward zero as the number of securities in the portfolio is increased. This, of
course, is the result of diversification, which can reduce firm-specific risk, but
not market risk, to zero.

Hence, the alpha component and the residual risk tends toward zero as the
number of securities are increased, which reduces the single-index model
equation to the market return multiplied by the risky portfolio's beta, which is
what the Capital Asset Pricing Modelpredicts.

Profiting from Alphas with Tracking Portfolios

The decomposition of a stock's return into alpha and beta components allows
an investor to profit from stocks with positive alpha while neutralizing the risk
of the beta component. Suppose that a portfolio manager has identified,
through research, one or more securities that have positive alpha but the
manager also forecasts that the market may decline in the near future. The
positive alphas indicate that the stocks are mispriced, and, therefore, can be
expected to correct to their proper price in time.

To isolate the potential profits of the mispriced stocks, a portfolio manager

can construct a tracking portfolio, which consists of a portfolio that has a
beta equal to the portfolio with the positive alpha stocks, and sell it short. This
eliminates market risk, since if the market declines, then the shorted tracking
portfolio will increase in value by the same amount that the long position will
decline due to its systematic risk as measured by its beta. Hence, the
manager can profit from the positive alphas without worrying about what the
market will do. Many hedge funds use this long-short strategy to profit in
any market.